“Be still indebted to somebody or other, that there may be somebody always to pray for you, [. . .] fearing, if fortune should deal crossly with you, that it might be his chance to come short of being paid by you.” — François Rabelais, Gargantua and Pantagruel, Book III
Pundits worldwide are debating what to do with all the public debt accumulated since the global financial crisis (GFC) and during the pandemic. The most extreme have called for central banks, which are engaged in fiscal quantitative easing by monetizing government debt, to cancel their holdings altogether.
Modern monetary theorists claim that hiking national debt is inconsequential while their detractors describe US default as inevitable. Others less dramatically vaunt the merits of turning that stock of debt into perpetual sovereign bonds. France has stored its “covidette” in a special-purpose vehicle until it figures out how to do just that.
The Way Things Were
If chronically hard-pressed governments end up picking the “perpetuity” option, the private sector has demonstrated how to proceed.
At the turn of the millennium, corporate loans were rigidly structured. They had a specified maturity, a strictly negotiated repayment schedule for amortizable facilities, a set margin for LIBOR- or EURIBOR-based loans, or a fixed cash coupon for bonds.
Loans were tightly covenanted, with an agreed-upon buffer called headroom, established above a coverage ratio to act as an early warning mechanism for covenant breaches.
The borrower was obligated to notify debt providers when a breach was likely. The terms were then renegotiated and conditional on the lenders’ consent.
Finally, loans came up for full repayment upon maturity or in case of a corporate event, thereby triggering a “change of control” clause.
Gradual Erosion of Obligations
As so often happens in financial markets, matters evolved imperceptibly until debt products were totally transformed, almost beyond recognition.
Credit has become the main source of capital over recent decades. As financial risk increased, so did the frequency of restructurings. Examples abound of distressed businesses in need of recapitalizations or amend and extend (A&E) procedures, even during the boom years of the early noughties.
In 2004, for instance, when trying to save one of his resorts, future US president Donald Trump made the best of a bad situation, pointing out, “We’re in the process of reducing the debt by about $544 million . . . the interest rate from approximately 12 percent to 7.875 percent, and we’re extending the debt out for about 10 years. It frees up $110 million a year in cash flow.”
Around that time, as the economy heated up, debt contracts adopted looser practices. Even mortgages were offered without much due diligence — remember NINJA loans?
Corporate borrowers benefited from relaxed contractual terms. Standstill agreements, whereby lenders pledge not to enforce action in case of a covenant breach, became common.
Other developments gave heavy corporate debt users a distinct advantage. In 2006 and 2007, covenant-light, or cov-lite, loans gained mass appeal, granting borrowers more flexibility in how they managed operations but limiting creditors’ options during loan defaults.
Addressing Cash Flow Shortfalls
Another fad spread in pre-2008 private markets: the extension of payment-in-kind (PIK) bonds. These instruments lower immediate or short-term cash demands, turning bond coupon payments into non-cash items. Interest accrues as it falls due, to be repaid upon maturity together with the principal.
The 2004–2007 credit bubble made responsible liquidity management crucial. Inasmuch as coupon redemption was scheduled and guaranteed, it hampered dividend distribution.
The impact that the time value of money (TVM) has on fund managers’ investment returns makes PIK notes extremely attractive, freeing up cash to upstream dividends early on in the life of an investment.
The removal of any amortizable tranche was another loan package feature that grew more common. Leveraged transactions traditionally included a senior loan A, the debt structure’s most-secured layer. More leveraged buyouts (LBOs) were financed with no term loan A, so all tranches were non-amortizable “bullet” loans, which reduced cash requirements further.
“Equity cures” also proliferated. These addressed the covenant breach problem by allowing private equity (PE) owners to commit more equity to a troubled portfolio company. The trend proved prescient as economic conditions deteriorated. In 2008, 46% of covenant breaches were cured by fresh equity injections, compared to one-third the year before and one-fifth in 2006.
The high-profile failure of the EMI buyout showed how flexible these agreements had become. By the time the music publisher went bust in 2011, its PE-backer Terra Firma had spent hundreds of millions of pounds curing breaches of EMI’s net-debt-to-EBITDA ratio. In fact, its lender, Citi, had generously granted Terra Firma “unlimited cure rights.” But that proved ineffective.
Dodging and Fudging
During the financial crisis, numerous zombie buyouts faced a colossal debt overhang. Many were wrecked by the stigma of serial capital restructurings.
Financial sponsors learned from that ordeal. Ever since, they have sought to remove any remaining impediment to the free exercise of their trade. The past decade shows the strength of their negotiating power vis-a-vis lenders.
Predictably, A&E went mainstream, if only to push out the debt maturity wall. Some lenders became more aggressive and tried to gain control of distressed assets — often through deeply discounted loan-to-own transactions. But on the whole, long-term, close-knit relationships with lenders enabled PE owners to reschedule loans.
Loan renegotiations were time consuming and impacted returns due to the TVM effect. Buyout sponsors reinstated cov-lite loans as soon as practicable. These structures had disappeared during the Great Recession. In 2013, they represented over half of leveraged loan issuance. By 2019, they accounted for more than 80% of originations globally.
Another post-GFC development was even more momentous.
Although pro forma or run-rate earnings metrics have long helped persuade counterparties to finance a business, fudging the EBITDA — a non-audited operating cash flow proxy — with fanciful adjustments has become a favorite trick among PE firms since 2014. Addbacks serve one purpose in particular: curing potential covenant breaches without injecting fresh equity, an expensive practice both from a liquidity and rate of return standpoint.
Portable Means Transferable
All these tools — A&E procedures, loose covenants, equity cures, bullet and PIK loans, addbacks, etc. — helped shift many debt-associated costs and risks from the borrower to the lender during the 2008–2010 credit crunch and its aftermath. But they failed to completely eliminate the many pitfalls of permanent leverage.
The cherry on the LBO cake would be granting borrowers the option to never repay their loans or, at the very least, to make debt redeemable at their sole discretion rather than the whim of lenders.
In recent years, this possibility has gradually become a reality. Debt reimbursement is increasingly voluntary: In banking circles, PIK toggle notes are known as “pay if you want” loans.
Debt portability — making balloon repayments upon maturity optional — has also become topical. In such scenarios, leveraged businesses can be transferred from one PE owner to the next without triggering a “change of control” clause. This is critical given the prevalence of secondary buyouts.
Thanks to private capital firms’ improved bargaining power derived from a large share of M&A transactions and their role as credit providers, they have actually contrived to impose portability on dividend recaps, that is, even without any change of ownership taking place.
The Central Banker’s Put
Borrowers eager to manage the default risk away should not despair if lenders refuse to mitigate financial risk by making loans portable. They can count on another major trait of a debt-centric economy.
In August 2002, as the dot-com bubble continued to deflate, US Federal Reserve chair Alan Greenspan declared that while it was impossible for central bankers to identify an asset bubble and attempt to rein it in, they could “mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.” Critics noted the illogical reasoning behind this statement. Why should Greenspan feel more confident about calling the bottom rather than the top of a cycle?
At any rate, the obvious conclusion was drawn from Greenspan’s remarks: The Fed would intervene in times of trouble. This attitude came to be known as the “Greenspan put,” as it implicitly restricts the downside risk faced by investors.
It did not take long for the next crisis to erupt, providing an immediate test of this “Fed-sponsored bailout” doctrine. Millions of US mortgage holders were rescued in the wake of the GFC. Between November 2008 and March 2010, the Fed purchased $1.3-trillion worth of mortgage-backed securities issued by Fannie Mae and Freddie Mac, the two largest government-sponsored originators in the country.
By guaranteeing that, if required, they will relieve borrowers from the hardship of debt commitments, central bankers have provoked significant systemwide moral hazard. If personal default or bankruptcy is no longer an eventuality, in this “buy now, pay later” world, every citizen and corporation should pile on debt to spend at will.
Thus, the Greenspan put became the Bernanke put, and since the start of the pandemic, Jerome Powell has added his name to the series. Central bankers are doing their governments’ bidding by putting a floor under asset prices.
Unsustainable, Ergo Perpetual
Herbert Stein, who chaired the Council of Economic Advisors under presidents Richard Nixon and Gerald Ford, once remarked in reference to the nation’s balance of payments deficit: “If something cannot go on forever, it will stop.” But when it comes to government debt, we have probably passed the point of no return.
Even before the pandemic, total unfunded government liabilities in the United States, including pension entitlement, social benefits, and Medicare, exceeded $200 trillion. Absent the enactment of a modern Jubilee law through debt cancellation, extreme leverage will stay with us forever.
Non-perishable loans with interminable commitments are already in place in the corporate world. There is always a creditor out there willing to amend debt for a consent fee. A non-covenanted, portable loan whose commitments can be rolled over ad infinitum is perpetual in all but name.
Governments seeking the indefinite right never to redeem sovereign debt should borrow a leaf out of the private sector’s playbook. Converting long-term liabilities into perpetuities would morph 30-year Treasuries into 100-year bonds with low or negative yield. Of course, the term “bond” would be somewhat malapropos given the lack of binding repayment obligation.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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